Turf wars in black tie

Plans to avoid another crisis prompt feuding within Britain and with Europe

THE midsummer dinner with bankers at Mansion House, the Lord Mayor's home in the City of London, offers chancellors of the exchequer a chance to address pressing economic and financial issues. For Alistair Darling (pictured left), who came close to losing his job in Gordon Brown's recent cabinet reshuffle, the very fact that he was there on June 17th was a triumph of sorts. But the occasion was spoilt for him by a public row with the other speaker, Mervyn King (pictured right), governor of the Bank of England.

Both the chancellor and the governor wanted to tell the banking bosses how the financial system could avoid repeating last October's near-death experience. Mr Darling said that the banks needed to put their own houses in order, but he also accepted that better management would not be enough. Financial supervision must be made more effective.

There is broad agreement that this will require two main reforms. First, supervision must be top-down as well as bottom-up. In the jargon of the hour, it should be “macroprudential”, monitoring the financial system as a whole, as well as “microprudential”, keeping an eye on individual firms. The new overseers will identify systemic risks such as dangerous credit surges and counter them, for example by telling banks to hold more capital. And second, existing microprudential supervision must be smarter and tougher.

But who should be in charge of a reformed regulatory system? The question is politically charged because it calls into question Mr Brown's seminal reform 12 years ago. As chancellor, he freed the Bank of England to set interest rates but handed its supervisory powers over banks to the Financial Services Authority.

Small wonder, then, that Mr Darling announced no big regulatory shake-up as his Treasury prepares a policy paper on reform that is due to be made public shortly. Instead he pointed out that no one model of regulation had insulated a country from the crisis. Judgments based on clear analysis mattered more than rejigging institutions to implement a new approach: “to concentrate only on institutions seems to me to miss the point”.

Mr King could hardly have dissented more bluntly. He accepted that the central bank had been given new powers to deal with banks that run into trouble, and that it now had a statutory responsibility for financial stability. But more tools were needed. Likening the central bank to a church, he feared that its congregation would disregard the vicar's exhortations, however thunderous: “Experience suggests that attempts to encourage a better life through the power of voice is not enough.”

In effect, then, Mr King said that institutions do matter, that the institution which should be in charge of macroprudential regulation is the central bank and that it needs a new toolkit. Embarrassingly for the Labour government, that puts the governor squarely in the camp of the Conservatives, who have already argued that the Bank of England should run the new-style macroprudential regulation.

The governor also crossed swords with the chancellor on whether more fundamental changes were needed. He said that banks thought to be too big to fail are too big. Mr Darling, by contrast, maintained that the solution to this problem was not as simple as restricting the size of banks.

If there is a war over who should be the supervisory supremo in Britain, there is also a battle within Europe. High on the agenda of the meeting of European Union leaders on June 18th and 19th was a proposal for far-reaching reforms to shift more regulatory power to the European level. The case for change is that the financial crisis has exposed a dangerous gap: many markets and banks operate across Europe but supervision remains a national affair.

As in Britain, the reforms would introduce macroprudential supervision. A “European Systemic Risk Board” (ESRB) would sound the alarm over dangers to financial stability throughout the EU and suggest how to avert them. The board would include the governors of the EU's national central banks and be chaired by the president of the European Central Bank (ECB). In addition, a “European System of Financial Supervisors” would push for more convergence in financial regulations, exert more influence over national supervisors and, where necessary, resolve differences among them.

Mr Darling accepts that there should be more co-operation both in Europe and globally to promote financial stability. He has argued the case for a body to set financial standards across the EU. But he and Mr Brown are unhappy with both the European proposals. Although the ESRB would lack legally binding powers, the Treasury dislikes the idea of the ECB's president chairing what would be the EU's macroprudential overlord. And it believes conventional banking supervision must remain a sovereign responsibility. National taxpayers are called upon if banks run into trouble and have to be bailed out.

But a government beset by electoral setbacks and party in-fighting is on the back foot in seeking to temper the plan. When European finance ministers met on June 9th, they recognised that European supervisory rulings should not impinge on national fiscal sovereignty. But the substance of the reforms still looks set to go ahead.

But the most awkward problem now for Mr Darling is how to respond to Mr King's pitch for more power. If he gives ground, this will be interpreted as weakness. But if he tries to muddle through then Tory counter-proposals will be given added weight by the governor's open dissatisfaction with current arrangements. Mr King may have likened himself to a vicar, but the chancellor may well regard him as a turbulent priest.